Many of you are familiar with the concept of a nonrecourse commercial real estate mortgage loan, where the lender acknowledges that neither the borrower nor its equity owners, affiliates, related officers and employees are, in general, not personally liable for the payment of the mortgage debt. Since the mid-1980s, the so-called “carve-out” or “bad-boy” guaranty has commonly been used by lenders as part of this structure. As a result of holdings in a number of recent cases involving these guaranties, this article (and several future articles) will discuss:

the unintended risks which the courts have now indicate that the carve-out guarantors may be exposed to (which in some cases include full repayment of the loan itself); and

some techniques that can be employed to avoid these risks.

A 70s Mortgage Loan Structure Comes of Age

As background, the nonrecourse mortgage loan structure began to emerge with some regularity back in the 1970s. Real estate promoters and syndicators discovered that they could get lenders to issue these types of loans, which restricted the lender to look to the mortgaged property and related assets for collection if a mortgage default occurred and remained uncured. This structure became popular because these promoters and syndicators needed to bring into their deals passive investors to provide equity (since these investors were primarily interested in receiving income and tax depreciation benefits but they were not willing to be exposed to collection risk, if the mortgage loan went into default). By using this structure, real estate promoters found they could utilize limited partnerships (and subsequently limited liability companies) as the vehicle to own real estate, with the result that the following outcomes could be achieved:

the promoters were able to own the property-owning entity, and the promoters were able to retain operational control over the real estate;

the investors were able to receive the tax depreciation benefits and income from the property; and

the promoter and the investors who owned interests in the property-owning entity were released under the primary loan documents from any direct recourse relative to most mortgage loan defaults.

Lenders Seek Carve-Out Guaranties

In recent years, as part of the nonrecourse loan structure, lenders have been requiring that a carve-out guaranty be entered into by one or more individuals or entities, but not including the mortgage loan borrower (whose assets were already encumbered to secure the mortgage loan). The guarantors under these guaranties, were typically credit-worthy parties who were related to the real estate promoters. The early carve-out guaranties focused on giving the lender’s recourse to:

recover damages incurred by the lender, arising from designated “bad acts” performed by the mortgage borrower or related parties, which included fraud, theft, intentional destruction of any the real estate property, misapplication of insurance proceeds or condemnation awards, material misrepresentations, etc.; and

obtain repayment of the mortgage loan, if (a) the mortgage borrower should file a voluntary bankruptcy or colludes in having an involuntary bankruptcy filed against it, or (b) there should be a transfer of any portion of the mortgage property or any equity interests in the mortgaged real estate or any equity interests in the mortgage borrower or any material direct or indirect equity owner of the mortgaged borrower. These carve-outs were also included in the primary loan documentation relating to the mortgage loan.

Courts Weigh In

It has now become clear that the courts will allow lenders to enforce exclusions in the loan document’s non-recourse provisions even those that would impose full liability to pay the entire loan if such provisions are violated. In Heller Financial, Inc. v. Lee 2002 WL 1888591 (N.D. Ill., August 16, 2002), the court held that that the lender could collect for damages relating to a mechanic lien that had been filed against the mortgage property, which was in line with a corresponding carve-out provision set out in the nonrecourse section of the note. The court found that such enforcement did not constitute a penalty, because the section of the note dealing with this nonrecourse carve-out provided the lender with a means to recover its unpaid debt, which correlated to its actual damages (i.e., the amount of the unpaid indebtedness) and therefore such enforcement was not related to recovering liquidated damages. See generally, Andrew H. Levy, ‘Bad Boy’ Guarantees – Courts Are Enforcing Non-Recourse Carve-Outs, N.Y.L.J., July 30, 2003.

This case, as well as many others that follow this holding, make it clear that courts will allow lenders to enforce carve-out provisions, in accordance with the terms, even if it results in the defendant having to pay-off the balance of the loan, where applicable. Therefore it is imperative that each of these provisions be scrutinized carefully before they are entered into, and where possible be limited in scope. In addition, to avoid unwanted liability, all mortgage borrower related parties, most particularly guarantors under carve-out guaranties, need to be careful that actions not be taken which could trigger this liability, and not to take this risk exposure lightly. In future articles, I will discuss, some of the recent court cases in this area which have resulted in carve-out guarantors being socked with huge judgments relative to their carve-out guaranties.